Commentary and analysis on markets, personal finance, and wealth building from a contrarian perspective. "I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting there and trying to dream it up all yourself. Nobody’s that smart."
— Charlie Munger

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Sunday, July 31, 2016

Position sizing: another tool to limit portfolio risk

The US is a country that has tons of stories about the guy that put it all on the line on one oil well or one mine and hit it big. I believe it is called a Horatio Alger story. Those rags to riches stories are fun to read but in the real world what normally happens is the person that puts it all on the line for one roll of the dice typically comes up snake eyes.

Investing and in particular speculating in the capital markets requires discipline and cash management. You will not be correct in many of your stock selections. Using strict stop losses is one way to manage and limit risk and I talked about using stops here.

I typically do not go above a 3% allocation to any one position. For illustration purposes assume a person has a $100k position. That means that I would not go above $3 for any specific position. In some cases I will go above the 3% threshold this if the situation really looks good.

Continuing with the $100k portfolio example from above and a $3000 position sizing and coupling that to a 25% stop loss the most I would have at risk on any position is $750 or .75% of the total portfolio.

As you can see combining the use of stop losses and position sizing goes a long way to keeping your portfolio from experiencing large draw downs. As I have stated in the past the one thing we need to avoid is a big draw down to our portfolio. I believe I can pick stocks that go up consistently enough to make money. Staying in the game with enough of a bankroll to take advantage of the upside by limiting losses and letting winners run is the name of the game.

I am using stop losses and position sizing to manage my bankroll. I am using these rules to take the most emotion and ego out of my investment decisions as I can. These tools have helped me and I am sure if you incorporate them into your tool kit you will have success also.